An option is a right to buy or sell a specific amount of stock at a specific price of a specific company (or group of companies). Options always have a set time period in which they may be exercised.
In his Wall Street Journal article, “More Investors Play the Stock-Options Lottery”, Randall Smith reports that due to individual investors jumping into the market, stock market volume has more than doubled since the year 2000. However, the volume of stock options trading has grown to more than six times what it was in 2000 (2020). According to the Options Clearing Corporation, the average daily trading in options on stocks was about 21,000,000. On September 13, 2020, the Wall Street Journal reported that options trading on shares was 120% of the buying and selling of stock shares. These options are mainly on high-tech companies that are flying high right now, directly as a result of COVID-19 and the switch to online shopping. Further, the Wall Street Journal reported that share values optioned by small investors was $500 billion.
There are two main types of options: Call Options and Put Options. A Call Option gives you the right to buy shares of a stock. A Put Option gives you the right to sell shares of a stock. If you decide to invest in options and are convinced that the price of a certain stock will go up, you will buy a Call Option. The way you make money is to wait until the stock price goes up and then exercise the right to buy at the lower price. Alternatively, the price of the option will rise as the price of the stock rises, so you do not have to even exercise the option to reap your profits. You can just sell the option on the market at a higher price. If you are convinced that the price of a certain stock will go down, you will buy a Put Option. The price of the Put Option will rise when (and if) the price of the stock drops, and you can reap your profits just by selling the option in the market.
Let’s look at an example of a Call Option. On January 1, you purchase 100 Call Options to purchase Apple stock at $250 per share to expire on March 31. The price of the options is $2 each.
If Apple stock rises to $255.00 the options price will typically rise by the same amount.
You sell the options on the market, and your profit and return are thus:
The value in buying options rather than Apple stock is that your returns are multiplied. If you bought 100 shares of Apple stock at $250, and its price rose to $255, your profit and return can be expressed like this:
Looks great, huh?
The problem is that your timing could be off. If Apple does not rise in price by March 31 (or drops in value by March 31), your Call Options will expire as worthless, and you will lose your $200. The $2.00 per option that you paid is called the time premium or premium, and it decays or decreases the closer you get to the expiration date. This means that the option that you paid $2.00 for is worth $0 on the expiration date if the stock price has not risen above your exercise price.
For every buyer of a Call Option, there must be someone willing to sell a Call Option. There will be some sophisticated investors on the other side of your Call Option betting that Apple stock will not go up (or will decline) in price by the end of March 31. According to Smith’s Wall Street Journal article, online brokers such as TD Ameritrade and E*Trade are aggressively promoting options trading to small investors. It is much more profitable to them to sell options as opposed to stocks. My advice for the individual investor is to stay away from options. Think about it this way: if about two thirds of individual investors lose money in options, you would do better to place your money on red or black on the roulette wheel at your local casino. On that bet, your odds are 50/50, and you double your money if you win.